by Andreas Hoffmann and Mario Rizzo
We know from Wicksell’s (1898) Interest and Prices, there is something important about the interest rate that balances saving and investment in an economy over time. This equilibrium interest rate is called the “natural rate of interest”. When market interest rates are below the natural rate, an unsustainable credit boom which distorts the production structure in the economy and inflation are the result.
In line with this idea, most economists agree – today – that the Fed held interest rates “too low for too long” following the burst of the dot-com bubble. As expected, this contributed to a credit boom in the US economy. With the emergence of the crisis, the Fed lowered interest rates to stabilize the price level, financial system and output. Yet, a year of recovery is over and interest rates are still low. What about the natural rate today?
Admittedly, it is hard to find a reliable number for the natural rate. In the end, it is a market rate that is hard to know. Throughout the literature the concept is used in variations. The rate reflects time preferences of market participants and allocates resources efficiently (See Garrison). Some refer to it as the average period of production (hard to measure). Since it is the rate at which money supply is neutral – thus it creates no distortions and no inflation – in Wicksell’s and Hayek’s frameworks, it can also be seen as something close to the equilibrium rate that comes out of a Taylor rule.
Laubach and Williams (2003) provide an estimate for the natural rate. It is on average 3.2 percent. Since this was in 2003 and the natural rate has a downward-trend in their paper, the rate may be lower today. Laubach and Williams show that the natural rate is strongly related to output growth and falls in times of crisis. It is not stable. Thus, during a crisis as in 2001 the natural rate was 1 percent, while it is was at 5 percent in the previous boom.
To hold market rates close to the natural rate, the Fed has to lower interest rates during the crisis and raise them in the boom. Hence, stabilizing the market rate at the level of the natural rate is similar to stabilizing Fisher’s real rate. When we want to stabilize the real rate we have to adjust the nominal interest rate by the expected inflation rate (plus the cross product). But now, we want to hold the real rate at the level of the natural rate. Thus, when the natural rate falls, the real rate we aim at has to fall, too. From this perspective, it was probably correct to lower rates during the turmoil.
But what about today?
First some data: Since the natural rate seems to be closely related to the average real growth rate, we calculated an average of the growth rate from 2000 to 2011. It is 2.5 percent. This is close to the Laubach and Williams measure (3.2 percent – X) and therefore sufficient for an argument in a blog post. We assume 2.5 percent to be the average real natural rate of interest. Further, expected US inflation for 2011 is about 2.6 percent. This is an average of four indicators to estimate future inflation between 1.6 and 4 percent (WES, WEO, Michigan consumer expectations, current inflation). The nominal fed funds rate is currently at 0.25 percent.
A quick shot analysis: The real policy rates are about negative 2 percent. Many commentators argue that this is not problematic since banks do not lend freely due to risk aversion that stems from the latest crisis experience. However, this rate already translates into 1.8 percent real rates on mortgages and 0.8 percent real interest rates on car loans (BOA: March 2011, We simply subtracted expected inflation of 2.6 percent). Hence, the average credit rate is below the average long-run natural rate of 2.5 percent.
As the economy grew above trend last year and is expected to grow by 2.5 percent this year, from the arguments above, it would be odd to assume that the natural rate is currently below its long-run trend. Banks already pass on low central bank rates to customers. If the risk appetite of banks increases, credit supply will rise and credit rates will fall even further below the natural rate, given the cheap refinancing costs. Thus, nominal policy interest rates are too low and have to be raised to prevent another unsustainable credit boom and inflation. But central bankers seem to hesitate to do so – perhaps – for political reasons.